AP Econ: Chapter 21

Fiscal Policy

The federal government’s tools to impact the economy. These tools include changing the amount

of government spending and changes in the amount of taxes levied.

Fiscal Policy can be both Automatic (non-discretionary) and Discretionary.

Automatic Fiscal Policy = Federal expenditures and tax changes that are already in place. Fiscal

Policy tools already passed by Congress and in place that kicks in automatically. These policies are

said to lean against the prevailing (economic) winds.

Discretionary Fiscal Policy = New Government spending and/or tax changes. Something that

was not already in place or a change to something in place that Congress would have to meet and

vote on.

Fiscal Policy will either be expansionary OR contractionary as well….

Expansionary Fiscal Policy = designed to help an economy with unemployment issues or that might be in a recession…. there is a recessionary gap in the graphical analysis.

Expansionary Fiscal Policy tools =

1) Increase Government (Spending Multiplier equation is used)

2) Cut Taxes (Tax Multiplier equation is used)

3) Increase Government spending and taxes BY THE SAME AMOUNT (BBM used)

Contractionary Fiscal Policy = is designed to help an economy experience inflation. There is an inflationary gap in the graphical analysis.

Contractionary Fiscal Policy tools =

1) Decrease Government (Spending Multiplier equation is used)

2) Increase Taxes (Tax Multiplier equation is used)

3) Decrease Government spending and taxes BY THE SAME AMOUNT (BBM used)

Equations

Spending Multiplier = SM = 1 / MPS

SM x DG = D RGDP or D AD

SM x DI = D RGDP or D AD

Tax Multiplier = TM = 1-SM

TM x DT = DRGDP or DAD

Balanced Budget Multiplier = BBM = 1

BBM x DG = DRGDP or DAD

Initial DG = DRGDP or DAD

MPC+MPS = 1

MPC = SLOPE of AE line (RISE/RUN)

Set the Multiplier equations equal to DAD when you use a AS/AD graph

Set the Multiplier equations equal to DRGDP when you use a AE/Output graph

For example, set all multiplier equations = +$2T

Recessionary gaps = + GDP Gaps

So… when you have a Keynesian graph, set all multiplier equations equal to the GDP Gap.

set all multiplier equations = -$2T

Inflationary gaps = - GDP Gaps

So… when you have a AS/AD graph, set all multiplier equations equal to the Horizontal Distance

between the AD curves. For example, set all multiplier equations = $2T

AD shifting to the RIGHT has a + ∆AD set all multiplier equations = $-$.1T

AD shifting to the LEFT has a - ∆AD

Summary of Fiscal Policy

Expansionary Fiscal Policy = helps unemployment & recessionary concerns

  • INCREASE government spending

  • DECREASE taxes

  • INCREASE both by the same amount

Contractionary Fiscal Policy = helps inflation

  • DECREASE government spending

  • INCREASE taxes

  • DECREASE both by the same amount

The above are demand-side policies to impact the economy. The classical branch focuses on the

supply curve to help the economy using fiscal policy tools known as Supply Side Economics.

Supply Side Economics (Reaganomics) = roots in the classical school of economics, became popular during the Reagan administration, alternate to Keynesian philosophy, became influential due to Stagflation in the economy, and the goal is to increase AS: lower taxes, lower business regulations, promote policy to lower the price of inputs, promote technological innovations, and possibly offer subsidies – if found necessary

The goal of the above policies would be to increase the AS. The supply-side policy is also trying to give people the incentive to WORK more, SAVE more, and INVEST more.

One main idea to achieve the goals above is demonstrated via the LAFFER CURVE. Named after supply-side economist Arthur Laffer. He argued that if taxes are too high, it would be possible to lower the tax rate paid by citizens and still generate more total tax revenue for the government by giving people the intent to work. They would work more since they get to keep more of the money they make, but by working more would pay a larger amount of money in taxes despite the lower tax rate.